Emerging Markets Don’t Deserve Dour Outlook

Emerging market stocks are facing an enthusiasm gap compared to the U.S. EM headwinds are coming from weak commodity prices, a strong U.S. dollar and trade uncertainties. We think there’s too much EM negativity, especially when looking long term.

On a valuation basis, EM stocks are more attractively priced than U.S. shares. With the forecast for continued double-digit earnings growth for EM, we think there’s good reason to think EM price multiples can expand going forward.

EM are prone toward more volatility than developed markets. We’re seeing the downside of that volatility now, but there’s also the potential upside to consider. History shows that when EM outperformance starts, it can last for long periods of time.

These days, U.S. stocks own the good headlines – the bull market that began in March 2009 is now the longest in history and the Standard & Poor’s 500’s rally has lifted it close to its January 2018 all-time high. Earnings growth is deep in double digits and even small caps are going great guns, with the Russell 2000’s strong gains for the year pushing it into record territory.

At the other end of equity market enthusiasm are emerging markets, where positive news is proving a rare commodity. Part of that can be traced to commodities, which have struggled in the face of a stronger U.S. dollar and diminished demand from China. Trade tensions between Washington and Beijing are also not helping.

When macro conditions get turbulent, as we’re seeing these days, it seems the U.S. market is the safe harbor of choice for many investors. So it may seem an odd time to make a case for emerging markets, but we believe the outlook for EM is too dour, especially when looking toward the longer term.

Start with valuations, where we always start as fundamental investors. By raising the denominator, strong earnings growth in recent quarters has brought down the current price-to-earnings ratio for U.S. stocks but those shares remain on the pricey side. Other fundamental measures, including price-to-book and price-to-sales, also indicate rich valuations.

Emerging markets are more attractively valued than the U.S. (and other developed markets), as they have not seen the same share price run-up as the U.S. even though EM earnings growth has been strong and appears broad-based. This leaves room for expanding P/E multiples as share prices catch up with earnings gains.

The key macro headwinds mentioned earlier – demand pullback from China, trade uncertainties and a strengthening dollar – are in our view likely to be short-term impediments for EM, and we think they are priced in (or at least mostly priced in) by now.

As these factors play out – China shifts back into growth mode, global trade issues are clarified and the greenback stabilizes as U.S. monetary tightening runs its course – EM stands to benefit from the improving macro environment. We are maintaining our overweight to EM in our asset-allocation portfolios in anticipation of this reversal.

Much is being made of the troubles in Turkey, where internal politics are largely to blame for a slowing economy, sagging domestic stock market and a plummeting currency. We think Turkey’s potential to trigger contagion among other EM is being overblown – it represents less than 1% of the MSCI Emerging Markets Index.

And unlike Turkey, other EM countries with more stable balance sheets are responding to external pressures by raising interest rates to support their currencies, or they are letting their currencies revalue against the stronger dollar. These currency adjustments stand to help boost exports going forward and help balance out the costs of servicing dollar-denominated debt.

EM are prone toward more volatility than developed markets. We’re seeing the downside of that volatility now, as investors express their near-term concerns by moving risk assets into what they see as safer markets. That same volatility carries a potential upside as well, when market conditions swing toward EM. And history shows that when EM start thriving, their outperformance compared to developed markets has lasted for long periods of time.

This material is provided for informational purposes only by USAA Asset Management Company (AMCO) and/or USAA Investment Management Company (IMCO), both registered investment advisors. The material is not investment advice and is not a recommendation, an offer, or a solicitation of an offer, to buy or sell any security, strategy or investment product. The views and opinions expressed in the material solely reflect the judgment of the authors, but not necessarily those of AMCO, IMCO or any affiliates as of the date provided and are subject to change at any time. All information and data presented herein has been obtained from sources believed to be reliable and is believed to be accurate as of the time presented, but AMCO/IMCO does not guarantee its accuracy. The information presented should not be regarded as a complete analysis of the subjects discussed. Any past results provided do not predict or indicate future performance, which may be negative. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of AMCO/IMCO and USAA.

Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.

The unmanaged MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

Asset allocation does not protect against a loss or guarantee that an investor’s goal will be met. Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.